What are the consequences of expatriation for US citizens?

FRIDAY, JULY 6: Expatriation rules were enacted in 1966, revised in 1996, 2004 and 2008.

Current rules impose the same triggers as 2004 law but have dramatically different implications.

For expatriations occurring prior to 2008, there is 10-year reporting period on an expanded category of US source income and an expanded category of US situs assets.

For expatriations occurring after 2008, there is a mark-to market tax on worldwide assets, a 30 per cent withholding tax on future distributions from nongrantor trusts, i.e., any trust of which expatriate is not grantor, and a succession tax on gifts or bequests from the expatriate to US donees.

Triggers to application of rules

• Expatriate has a net worth of $2 million or more on date of expatriation (“net north test”) or
• Expatriate has an average net income tax liability for the 5 years preceding expatriation of more than $151,000 (indexed for inflation, this is 2012 figure) (“income tax liability test”) or
• Expatriation fails to certify, under penalties of perjury, that he has complied with tax filing obligations for the 5 years preceding expatriation (“tax certification test”).

Consequences

• Covered expatriate subject to tax on built-in gains in assets as if he sold them immediately prior to expatriation; can exclude $651,000 from gain (adjusted for inflation; this figure is 2012 figure)
• An individual is considered to own property included in his estate under estate tax provisions as if he died immediately prior to expatriation
• All nonrecognition deferrals and extensions of time for payment of tax are considered terminated as of the day before expatriation
• 30 day “wash sale” rules do not apply
• Election available to defer tax on an asset-by-asset basis until asset is disposed of, if adequate security is provided, treaty benefits are waived and interest is paid on the deferred tax
• A succession tax applies in the hands of US persons on gifts or bequests received from a covered expatriate at the highest applicable estate and gift tax rate
• There are exceptions for annual exclusion gifts, marital and charitable transfers but there is no offsetting gift or estate tax exemption available
• If a gift or bequest is made to a foreign trust, the succession tax applies to distributions made from the trust to US beneficiaries
• A trust can elect to be a US trust for this purpose
• The succession tax attributable to the income portion of the distribution can be credited against income tax imposed on same.

Grantor Trust or Nongrantor Trust?

• If a non-US trust is established and funded by a non-US person and qualifies as a “grantor trust” for income tax purposes, it is disregarded as a taxable entity and grantor is taxed on income of trust as its owner
• Correspondingly, if income of trust is not US-source income or effectively connected income, grantor is not subject to income tax
• Distributions to US beneficiary are treated as gifts from non-U.S. grantor and not taxed
• A non-U.S. person is not treated as owner of trust under grantor trust rules generally, unless trust meets either “Revocable Trust Exception” or “Trusts that Distribute only to Grantor and/or Grantor’s Spouse Exception”.

Grantor trust holding directly Non-US Situs assets

There are several benefits.

1. No income tax (except U.S. withholding on US source income) paid by trust, non-US grantor or U.S. beneficiary

2. No estate tax on death of non-US grantor (because US-situs assets held through non-US corporation) or on death of U.S. beneficiary (if assets stay in trust)

3. No generation-skipping transfer tax if trust continues in perpetuity.

Death of Non-U.S. Grantor

• Trust becomes a non-grantor trust and distributions of “distributable net income” to U.S. beneficiary are taxable
• If the distributable net income is not distributed, it becomes undistributed net income
• Distributions in excess of distributable net income and fiduciary accounting income, are deemed to come from undistributed net income, i.e., no tracing rule, and subject to “throwback rules:”
• Accumulated capital gains taxed as ordinary income
• Throwback tax applies under a three-out-of-five year averaging method
• A nondeductible interest charge is imposed on the throwback tax under a weighted average method
• Unless the trust requires the income to be distributed to a beneficiary, each distribution carries out a pro-rata share of DNI for the entire year and if it exceeds DNI, a pro-rata share of UNI, to US and non-U.S. beneficiaries alike
• A distribution equal to all DNI and UNI can be made to non-US beneficiaries in one year followed by a distribution to US beneficiaries in another year
• Broad intermediary rules exist to capture distributions made through non-US intermediaries to US persons.

James Paul Sabo, CPA, president, ETS Limited in Bermuda is a US tax specialist.

Part 1: US citizens still need to file their tax forms

The third and final instalment in this series will run on Wednesday, July 11.